Say a building throws off $1.5M of NOI a year. A Treasury pays 4.00% with no risk. A building can lose a tenant or need a roof, so you want more, and that extra is the risk premium. Together they are the cap rate, and NOI divided by the cap rate is what you pay. Drag either rate and watch the price move.
What the building is worth
NOI a year$1.5Mheld still
÷
Cap rate6.00%4.00% + 2.00%
=
Value$25.0Mwhat you pay
Property valuation against the cap rate. The dot is where you are.
A safe investment and this building on one percent axis. The dotted lines carry the two rates across both bars.
A safe investmentA 10-year Treasury pays 4.00% with no risk
This building4.00% + 2.00% for the risk = 6.00% cap rate
Return on investment0%2%4%6%8%10%12%14%
Risk-free rate4.00%
Risk-free rate4.00%Risk premium2.00%
Risk-free 4.00%Cap rate 6.00%
Risk-free rate4.00%
Risk-free rate4.00%
Risk premium2.00%
Cap rate6.00%
Swipe sideways to see all three bars.
A safe investment4.00%
Risk-free rate4.00%
This building6.00% cap
Risk-free rate4.00%
0%2%4%6%8%10%12%14%
Return on investment
Risk-free rateRisk premium
Risk-free 4.00%Cap rate 6.00%
4.00%A 10-year Treasury pays this with no risk
2%: rates are low6%: rates are high
2.00%What you want on top for the risk: a 6.00% cap rate
0%: as safe as a Treasury6%: a lot can go wrong
What just happened
A safe investment pays 4.00% a year. This building can lose a tenant or need a new roof, so you want 2.00% more, and at a 6.00% cap $1.5M of NOI a year is worth $25.0M. Push the premium up a quarter point and the same NOI is worth $24.0M.
Relevant formulas
Cap ratethe risk-free rate plus the risk premium4.00% + 2.00% = 6.00%
ValueNOI divided by the cap rate$1.5M ÷ 6.00% = $25.0M
Real cap rates also move with rent growth and with how easy the building is to finance; the picture holds NOI still and leaves those out.
Ask AI about this module
Answers come from Claude and can be wrong. The formula card is the source of truth.